michael dimond school of business administration

Michael DimondSchool of Business Administration

ValuationFIN 449

Michael Dimond


Calculating Free Cash Flow to Equity

• FCFE = Net income – Net investment + Net debt issued

Need to adjust this slide


Net Investment

• Net investment = (Capital expenditures – Depreciation) + Increase in noncash working capital



CapEx

• Line item on Statement of Cash Flows?

• Calculate the changes (from year to year) of ALL long-term assets shown on the balance sheet.

• Find the total amount (for a given year) shown in the “Investing” section of the Statement of Cash Flows. Issues?



Depreciation

• “Basic definition” of net cash flow = net income + depreciation

• Non-cash expense

• In the “balance sheet” approach to define capital expenditures, depreciation is usually not incorporated explicitly. Why not?

• If the “Statement of Cash Flows” approach is used, one must explicitly subtract depreciation from capital expenditures (shown in the “Operating” section of the Statement of Cash Flows)



Non-cash Working Capital

• Noncash working capital = (current assets – cash) – current liabilities… what else?

• Noncash working capital = (current assets – cash) – (current liabilities – interest bearing debt included in current liabilities) Why?

• Why not include cash?



Net Debt Issued

• “Net” debt issued implies that one must take both debt issuances AND repayments into account

• Discussion: Constant Debt Ratio– Suppose a firm always finances new investment with a fixed debt ratio

(say, 30% debt and 70% equity, for example). The general equation for FCFE could be expressed as follows:

– FCFE = Net income – (1 – debt ratio)(Net investment)

OR– FCFE = Net income – (equity ratio)(Net investment)



Free Cash Flow to Equity

• FCFE = Net income – Net investment + Net debt issued



Damodaran has resources online

• http://pages.stern.nyu.edu/~adamodar/• His spreadsheets are not always as helpful as you might

want…• An example of a valuation summary he did in 2008

http://pages.stern.nyu.edu/~adamodar/


What Damodaran’s valuation summary looks like: September 2008


What Damodaran’s valuation summary looks like: October 2008


• Bear in mind, these were a summary. We will ultimately want something more detailed for a working document.


What does the DCF Model look like?

• What drives the figures?• How sensitive are they to basic inputs?

FC Year -> 1 2 3 4 5 Terminal ValueFCFE -> 7,941 9,291 10,236 11,262 12,376 102,804

PV of FCFE 6782.5928 6777.6741 6377.782 5993.5825 5625.4721 46729.87595SUM of PV 78,287

Cash 23,207 Terminal Growth Rate 4.5%

Total Value 101,494 Rf 2.95%Shares Outstanding 30,851 β 3.14

Value per Share 3.29$ MRP 4.50%Adj. Close Price at 12/31/12 3.51$


Damodaran shows different ways to compute CFs• To start, compute historic FCFF & FCFE for the past 5 years

FCFF = NI + Int(1-t) + Depr - ΔFA - ΔNWC

FCFE = NI + Depr - ΔFA - ΔNWC + ΔDebt - PfdDiv

FCFF = FCFE + Int(1-t) - ΔDebt + PfdDiv

FCFE = FCFF - Int(1-t) + ΔDebt - PfdDiv

• How accurate would it be to extrapolate the future cash flows from the past FCFE figures?• In other words, can we simply assume FCFE will grow X% forever?• Here are the historic FCFE for a company:

• Instead, we project the drivers of these figures for the future.• Compute FCFF & FCFE based on the forecast figures

2008 2009 2010 2011 2012110,737 53,050 (1,118) 5,024 25,071


Building the sensitivity table

What’s in the yellow cell in the middle of the table?(easier to click cells than type references)

=(NPV($E223,$H$206,$I$206,$J$206,$K$206,$L$206+($L$206*(1+I$218)/($E223-I$218)))+$G$209)/$G$211

You should be able to paste the foumula into the remaining cells in the table and get the correct results.

equals

group everything together

PV of cash flows

Ke from the sensitivity table

CF1

CF2

CF3

CF4

CF5 plus…

terminal value, using %s in

table

close the NPV function

add the cash

divide by the number of shares


Valuing the first company

Supplementary Material:• 96 Common Errors in Company Valuations

by Pablo Fernandez & Jose Maria Carabias http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151

• Questions to ask yourself about trends and financial statement analysis

• Data Source: EDGAR http://www.sec.gov

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151

http://www.sec.gov/


Valuation

• Value = Debt Value + Equity Value

• Equity Value / Shares Outstanding = “Correct” Price per Share

• Context & perspective come from comparables and other less robust methods

• Publicly traded company can be declared to be “overvalued” or “undervalued”


When to use Free Cash Flow to the Firm• Use Firm Valuation (FCFF)

(a) for firms which do not have an optimal capital structure (leverage is too high or too low), and expect to change the leverage over time. Debt payments and issues do not have to be factored into the cash flows and the discount rate (WACC) does not change dramatically over time.

(b) for firms which have only partial information on leverage available (e.g. interest expenses are missing).

(c) in cases where value of the firm is more relevant than the value to the shareholders (e.g. projects which create value).

• As a rule, firm valuation (FCFF) is a more flexible approach than equity valuation (FCFE).


FCFF – Circular Reasoning?

• To discount FCFF we use the WACC, which is calculated using the market values of equity and debt. We then use the present value of the FCFF as our value for the firm and derive an estimated value for equity.

• There appears to be some circular reasoning involved because the market values of equity and debt are both inputs in computing the cost of capital and outputs.

• To get around this issue, one could use an iterative approach: Re-estimate the WACC using the new estimated values, which would change the inputs and the cost of capital.

• There should be convergence at some point in this process, but is cumbersome.


When to use Free Cash Flow to Equity• When leverage is stable, you can use the short cut for

estimating free cash flows to equity (Firm Value – MV of Debt).

• Use Equity Valuation (FCFE)(a) for firms which have stable leverage, whether high or not, and

(b) if equity (stock) is being valued

• When leverage is changing, modeling cash flows to equity becomes problematic (How much cash will be raised from new debt issues? How much old debt will be paid off each year?).


Measuring Cash FlowsCash flows can be measured to

All claimholders in the firm

EBIT (1- tax rate) - ( Capital Expenditures - Depreciation)- Change in non-cash working capital= Free Cash Flow to Firm (FCFF)

Just Equity Investors

Net Income- (Capital Expenditures - Depreciation)- Change in non-cash Working Capital- (Principal Repaid - New Debt Issues)- Preferred Dividend

Dividends+ Stock Buybacks

To go from reported to actual earnings we may have to: Update earnings & data to the date of interest Make corrections from Accounting Earnings Adjust for One-Time and Non-recurring Charges


From Reported to Actual Earnings

Update- Trailing Earnings- Unofficial numbers

Normalize Earnings

Cleanse operating items of- Financial Expenses- Capital Expenses- Non-recurring expenses

Operating leases- Convert into debt- Adjust operating income

R&D Expenses- Convert into asset- Adjust operating income

Measuring Earnings

Firm’s history

Comparable Firms


Updating Earnings

• When valuing companies, we often depend upon financial statements for inputs on earnings and assets. Annual reports are often outdated and can be updated by using-– Trailing 12-month data, constructed from quarterly earnings reports.– Informal and unofficial news reports, if quarterly reports are

unavailable.

• Updating makes the most difference for smaller and more volatile firms, as well as for firms that have undergone significant restructuring.

michael dimond school of business administration

Documents

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michael dimond slide

debt rationet investment

noncash working capital

debt issuances

equity fcfe

constant debt ratio

fixed debt ratio